4.2 Audit Procedures

Summary

This lecture delves into audit procedures, emphasizing the auditor's role in selecting methods to gather evidence for financial statement assertions. It distinguishes between risk assessment procedures, tests of controls, and substantive tests, highlighting the importance of substantive procedures in detecting material misstatements. The script also covers various audit techniques, such as confirmations, analytical procedures, and the auditing of accounting estimates, providing insights into the auditor's toolkit for evaluating financial data.

Takeaways

• 📚 The scope of an audit refers to the audit procedures deemed necessary to achieve the objective of an audit, giving auditors the freedom to choose any procedures they determine are necessary.
• 🔎 Audit procedures are methods used by auditors to gather evidence to determine the validity of financial statement assertions, starting with assertions, leading to objectives, and then to the procedures performed.
• 🔍 Risk assessment procedures (WP) and further audit procedures (FAP), including tests of controls and substantive procedures, are crucial for understanding the entity and its environment, and for assessing the risks of material misstatement.
• 🛠️ Tests of controls assess the operating effectiveness of controls in preventing, detecting, and correcting material misstatements, while substantive procedures (test of assertions) are required to detect actual material misstatements.
• 📈 Substantive tests can be categorized into tests of details (transactions or balances) and substantive analytical procedures (SAP), with the former being required and the latter being optional.
• 🔗 The difference between tests of transactions and tests of balances lies in whether the auditor is testing the debits and credits (process of individual transactions) or the ending balance (existence of account balance).
• 🌐 Audit procedures according to nature include inspection, observation, inquiry, confirmation, computation or reperformance, tracing and vouching, reconciliation, and analytical procedures.
• 💬 External confirmations involve obtaining audit evidence from third parties through representations or information about specific items affecting financial statement assertions, with positive and negative confirmation being the two general categories.
• 📊 Substantive analytical procedures involve studying and comparing relationships among accounting data and related information to identify unusual fluctuations, with the predictability of relationships being a key factor in their effectiveness.
• 🔮 Accounting estimates, such as allowances for doubtful accounts or inventory obsolescence, carry inherent risks due to their approximation nature, and testing these estimates involves understanding management's process, developing independent expectations, and reviewing subsequent events or transactions.

Q & A

What is the primary purpose of audit procedures?

The primary purpose of audit procedures is for the auditor to gather evidence to determine the validity of the financial statement assertions.

Why is the scope of an audit important?

The scope of an audit is important because it refers to the audit procedures deemed necessary in the circumstances to achieve the objective of an audit, allowing the auditor to give a positive conclusion and reasonable assurance.

What are the two main categories of audit procedures according to purpose?

The two main categories of audit procedures according to purpose are risk assessment procedures (WP) and further audit procedures (FAP), which includes tests of controls and substantive procedures.

What is the difference between test of controls and substantive tests?

Test of controls assess the operating effectiveness of the controls in preventing, detecting, and correcting material misstatements, while substantive tests (both tests of details and analytical procedures) are designed to detect material misstatements at the assertion level.

Why are substantive procedures required to be performed in every audit?

Substantive procedures are required to be performed in every audit because they are essential in detecting material misstatements in the financial statements, which is the core objective of the audit.

What are the two general categories of substantive tests?

The two general categories of substantive tests are tests of details and substantive analytical procedures (SAP).

What is the main difference between inspection and observation as audit procedures?

Inspection involves examining records, documents, or tangible assets, while observation consists of watching a process or procedure being performed by others.

What is the significance of external confirmations in an audit?

External confirmations are significant as they provide audit evidence directly from third parties, which helps in corroborating information contained in the accounting records and related disclosures.

What are the general rules for the predictability of relationships when using substantive analytical procedures?

Relationships in stable environments and involving income statement accounts tend to be more predictable than those in unstable environments or involving balance sheet accounts. Additionally, relationships involving transactions subject to management discretion may be less predictable.

How do auditors test accounting estimates?

Auditors test accounting estimates by understanding how management develops the estimates, testing the process used by management, developing an independent expectation, and reviewing subsequent events or transactions.

What are some examples of common financial statement estimates that auditors might encounter?

Examples of common financial statement estimates include allowance for doubtful accounts, inventory obsolescence, depreciation, deferred taxes, provisions for losses, and warranty claims.

Outlines

00:00

📚 Overview of Audit Procedures

This paragraph introduces the concept of audit procedures, emphasizing their importance in gathering evidence to support the auditor's opinion on financial statements. It revisits the scope of an audit, which refers to the necessary procedures to achieve audit objectives. The auditor has the flexibility to choose any procedures deemed necessary, such as observations, interviews, physical counts, and cash counts. The paragraph also distinguishes between risk assessment procedures (WP) and further audit procedures (FAP), which include tests of controls and substantive procedures. The focus is on understanding the entity, its environment, and internal controls to assess the risks of material misstatement.

05:00

🔍 Substantive Procedures and Their Categories

This section delves into the importance of substantive procedures in detecting material misstatements in financial statements. It outlines two main categories of substantive tests: tests of details and analytical procedures. Tests of details can further be divided into tests of transactions and tests of balances, focusing on verifying the accuracy of individual transactions or the correctness of account balances, respectively. The paragraph also explains the difference between testing transactions (debits and credits) and testing balances (ending balances), using the example of accounts receivable.

10:02

🔎 Nature of Audit Procedures

This paragraph discusses the nature of audit procedures as outlined in PSA 500, detailing seven types of procedures. These include inspection (of documents and tangible assets), observation, inquiry, confirmation, computation or reperformance, tracing and vouching, reconciliation, and analytical procedures. Each procedure is briefly explained, highlighting their unique applications and limitations. For instance, observation is useful when there is no audit trail, but it can be affected by the 'Hawthorne effect' where people behave differently when they know they are being observed.

15:02

📋 Audit Procedures: Inquiry, Confirmation, and Computation

This section focuses on specific audit procedures such as inquiry, confirmation, and computation. Inquiry involves seeking information from knowledgeable persons, while confirmation is a more formal process that requires a written response to corroborate information. Computation or reperformance involves checking the mathematical accuracy of source documents and accounting records. The paragraph also distinguishes between tracing and vouching, explaining that tracing tests for completeness (starting from source documents to records) and vouching tests for existence (starting from records to source documents).

20:03

📉 Audit Procedures: Analytical Review and External Confirmations

This paragraph discusses the use of analytical review procedures in the testing phase, emphasizing the importance of developing expectations and determining acceptable variations. It also covers external confirmations, which involve obtaining audit evidence directly from third parties. The paragraph explains the difference between positive and negative confirmations and the conditions under which negative confirmations may be used. Additionally, it highlights the importance of using the client's letterhead for confirmation requests and the auditor's role in controlling the mailing and responses.

25:04

📊 Analytical Procedures and Their Predictability

This section explores the factors to consider when using substantive analytical procedures, such as the suitability of using analytics for specific assertions, the reliability of data, and the precision of expectations. It also discusses the predictability of relationships in stable versus dynamic environments and the differences between income statement and balance sheet accounts. The paragraph outlines the steps involved in using substantive analytical procedures, including developing expectations, determining acceptable variations, and investigating significant differences.

30:05

💼 Auditing Accounting Estimates

This paragraph focuses on the auditing of accounting estimates, which are approximations made in the absence of precise measurement. It lists common examples of estimates, such as allowances for doubtful accounts and inventory obsolescence. The procedures for testing accounting estimates include understanding management's process for developing estimates, developing an independent expectation, and reviewing subsequent events or transactions to validate the estimates. The paragraph emphasizes the inherent risks associated with estimates and the importance of validating them through subsequent events.

35:05

📚 Summary of Audit Procedures

In the final paragraph, the speaker summarizes the key points discussed in the lecture series on audit objectives, procedures, evidence, and documentation. The focus is on the importance of understanding management's process for developing estimates and the role of subsequent events in validating these estimates. The speaker also hints at the next topic in the series, which will be audit evidence and documentation, indicating a comprehensive approach to auditing financial statements.

Keywords

💡Audit Procedures

Audit procedures refer to the various methods or acts used by auditors to gather evidence for financial statement assertions. They are integral to the audit process and are designed to provide reasonable assurance on the validity of financial statements. In the script, audit procedures are discussed in relation to their scope and purpose, such as risk assessment, tests of controls, and substantive tests, which are all aimed at evaluating the entity's financial statements for accuracy and reliability.

💡Scope of an Audit

The scope of an audit pertains to the extent of work that is deemed necessary to achieve the audit's objectives. It involves the audit procedures chosen by the auditor to form an opinion on the financial statements. The script mentions that the scope allows the auditor the freedom to select any procedures deemed necessary for providing an opinion, emphasizing the importance of the auditor's judgment in the audit process.

💡Risk Assessment Procedures

Risk assessment procedures are used to understand the entity and its environment, including internal controls, to assess the risks of material misstatement in the financial statements. The script highlights their significance in the preliminary engagement activities and how they form the basis for further audit procedures, indicating their foundational role in the audit process.

💡Tests of Controls

Tests of controls involve verifying the operating effectiveness of the controls in preventing, detecting, and correcting material misstatements. The script explains that these tests are conducted when the auditor intends to rely on the entity's controls, and they provide evidence about the likelihood of misstatements, which is crucial for assessing control risk.

💡Substantive Procedures

Substantive procedures are designed to detect material misstatements at the assertion level. They are essential for providing an opinion on the financial statements' accuracy. The script discusses two types of substantive procedures: tests of details and substantive analytical procedures, emphasizing their importance in identifying actual misstatements.

💡Assertions

Assertions in the context of auditing are the representations made by the entity about the financial statement items. They serve as a basis for audit procedures and objectives. The script connects assertions with audit procedures, explaining how procedures are selected to test these assertions and ensure the validity of the financial statements.

💡Analytical Procedures

Analytical procedures involve the study and comparison of relationships among accounting data to identify unusual fluctuations or trends. They can be used in both the planning phase and as substantive tests. The script describes their use in identifying predictable relationships and investigating deviations that may indicate misstatements.

💡External Confirmations

External confirmations are requests for written responses from third parties to corroborate information contained in the accounting records. The script discusses the use of positive and negative confirmations, as well as blank confirmations, to test for existence and completeness assertions, highlighting the importance of direct control by the audit firm over the mailing and responses.

💡Accounting Estimates

Accounting estimates are approximations of amounts where precise measurement is not possible. They are inherently risky due to their subjective nature. The script mentions examples such as allowances for doubtful accounts and depreciation, and it outlines procedures for testing these estimates, such as understanding management's process and reviewing subsequent events.

💡Audit Evidence

Audit evidence is the information obtained by the auditor to provide a basis for the audit opinion. Although not explicitly defined in the script, the concept underlies the discussion of audit procedures, as all methods and acts described are aimed at gathering this evidence to support the auditor's conclusions about the financial statements.

💡Tracing and Vouching

Tracing and vouching are audit procedures that involve following transactions from records to source documents (tracing) or from source documents to records (vouching). The script explains these concepts as tests for completeness and existence, respectively, and emphasizes the importance of starting from the appropriate point based on whether the records are over- or understated.

Highlights

Audit procedures are methods used by auditors to gather evidence to determine the validity of financial statement assertions.

The scope of an audit refers to the audit procedures necessary to achieve the audit objective.

Auditors have the freedom to choose any procedures they deem necessary for the audit.

Risk assessment procedures are crucial for understanding the entity and its environment, including internal controls.

Test of controls involves assessing the operating effectiveness of controls in preventing, detecting, and correcting material misstatements.

Substantive procedures are essential for detecting material misstatements at the assertion level.

Substantive tests of details involve obtaining evidence on items or details involved in an account balance or class of transactions.

Substantive analytical procedures involve studying and comparing relationships among accounting data to identify unusual fluctuations.

Risk assessment procedures are required in a risk-based audit approach, as are substantive procedures.

Inspection includes examining records, documents, or tangible assets.

Observation involves watching a process or procedure being performed by others and has strengths and weaknesses.

Inquiry is seeking information from knowledgeable persons, while confirmation is a more formal inquiry requiring a written response.

Recomputation or reperformance involves checking the mathematical accuracy of source documents or repeating a client's internal control activity.

Tracing and vouching are opposite audit procedures; tracing tests for completeness, while vouching tests for existence.

External confirmations involve obtaining audit evidence from third parties in response to a request for information.

Positive confirmation requires a response in all cases, while negative confirmation only requires a response if there is disagreement.

Substantive analytical procedures are used to develop expectations and identify material misstatements by comparing actual recorded amounts.

Accounting estimates carry inherent risk due to their approximation nature and require specific audit procedures to test their accuracy.

Transcripts

let's now talk about audit procedures

now if you have been religiously

following our lecture series then you

would feel some sense of deja vu and you

might feel like hey wait this is

familiar and this will particularly take

you back to the second installment that

we had when we gave the overview of the

fs audit process we did talk about audit

procedures also there but for this

particular segment we're going to INF

flesh those Concepts a bit more K I hope

you're ready you already know that when

we talk about scope of an audit it

mainly just refers to the audit

procedures deemed necessary in the

circumstances to achieve the objective

of an audit and early on we made mention

that when we talk about the scope of an

audit actually the auditor has the

chance to choose the chance and the

freedom to choose any and all procedures

that the auditor determines is necessary

for the auditor to give an opinion we

mentioned that the auditor can do

observation the auditor can talk to

people the auditor can interview the

auditor can observe physical counts the

auditor can you know pursue or conduct a

cash count all of these things are

available to the auditor these arsenal

of procedures are available to the

auditor which will later on allow the

auditor to give a positive conclusion

and a reasonable Assurance now speaking

of audit procedures since scope of an

audit refers to audit procedures audit

procedures are the methods or acts that

the Auditors use to gather evidence so

the very purpose of audit procedures is

for the auditor to gather evidence and

we gather evidence to determine the

validity of the fs assertions we go back

to the Storyteller and the story and

evaluating the story in the course of

evaluating the story we need to gather

evidence and to gather evidence we need

to perform audit procedures so if you

can picture it out in your mind right

now well it starts with the assertions

from the assertions we come up with

objectives and the objectives will lead

us to the procedures that we will be

performing let's now look at the audit

procedures according to purpose and this

is the part where where you will feel a

strong sense of deja vu these are the

audit procedures according to purpose we

already know that we have risk

assessment procedures or WP and then we

have fap or further audit procedures

which is further comprised of test of

controls and substantive

procedures when we talked about uh

preliminary engagement activities audit

planning

materiality risk assessment Pro and even

internal controls risk assessment

procedures really took the center stage

and we said risk assessment procedures

are procedures used to obtain an

understanding of the entity and its

environment including its internal

controls to assess the risks of material

misstatement at the fs and assertion

levels we also recall that in the 2019

revision of PSA 315 there has become

lesser of a focus on obtaining the

understanding although of course it's

important it's a crucial part and more

weight is then given to risk assessment

so risk assessment procedures are

intended to assess the risks of material

misstatement and we said this is where

the gtky getting to know you would come

in and the auditor will get to assess

both inherent and control risk of the

client and we also made mention that

under risk assessment procedures we

basically perform the big three IO

inquire inspect observe and of course

included to that is analytical

procedures if performed in the planning

phase in the third installment we also

made mention that if you want to take a

look at the design and implementation of

the control in you know your aim of

assessing control risk you look at

design and implementation under risk

assessment procedures we also mentioned

that for the implementation part you

could perform a walkthrough test now

let's now take a look at test of

controls and we know that test of

controls test the operating

effectiveness of the controls in prev

ing detecting and correcting material

misstatements at the assertion level we

then made in the last installment a very

clear distinction that when the auditor

considers internal controls the auditor

considers it at the risk assessment

phase by performing WAP looking into

design and implementation and if certain

conditions are met where such as when

you intend to rely on the controls or in

the case of rspa risk for substantive

procedures alone can I provide

sufficient and appropriate evidence um

it's found it's all found in our third

uh installment when we talked about

internal controls you may want to pay

that visit if you need to you know

review these Concepts if those if those

conditions are met then we perform test

of controls otherwise then we don't need

to if you don't intend to rely on the

controls you don't need to test the

controls lastly of course we have

substantive procedures and substantive

procedures are there to detect Mis

material misstatements at the assertion

level that's why they are called test of

assertion

we have also highlighted the importance

of substantive procedures because at the

end of the day our objective is to give

an opinion on whether the financial

statements are free from material

misstatements and it would be

substantive procedures that would detect

those material misstatements we also

remind ourselves that of the three audit

procedures categorized as to purpose

risk assessment procedures are required

to be performed more so since we are

using the risk-based audit approach and

substantive procedures are also required

to be performed as as what we have

mentioned they are the ones that

actually detect the misstatements okay

now putting our Focus now on substantive

tests there are two general categories

we can call them substantive test of

details and these substantive test of

details could either be details of

transactions or details of balances so

when we mention substantive test of

details this will involve obtaining

evidential matter on the items or

details involved in an account balance

or class of transactions so as mentioned

they can be referred to as test of

transactions or test of balances for

this I'd like you to picture in your

mind draw in your mind a t account have

you already drawn it need to remember

the t account very useful tool for us

right so imagine the t account and

imagine there entry entries to the debit

and credit side of the t account then we

know from those entries and of course

the beginning balance we come up with

the ending balance right so if you want

to test the

assertions if what you want to do is to

perform substantive test of sorry if you

want to test the transactions if you

want to do if what you want to do is a

substantive test of transactions then

you will be testing the debits and the

credits okay that's a test of

transactions you test the process

procing of the individual transactions

normally by inspection of documents and

accounting records involved in

processing test of transactions is test

of debits and credits but if you want to

perform substantive test of balances

then you test the ending balance take

note the ending balance not the

beginning balance because the beginning

balance has already been tested as the

begin as the ending balance of the prior

year so when we say test of balances

it's test of ending balances so if if

you can imagine for example accounts

receivable if you want to test the

balance of accounts receivable then you

would normally do this one by performing

confirmation and sending a confirmation

letter or a confirmation request to say

the customer of your client and asking

the customer of the client to confirm if

they truly have a payable to the client

amounting to let's say 10,000 pesos as

of a certain date that's a test of

balance now we know that an account that

an account's receivable balance is

affected or made up by sales and then

reduced by collections but if we test

the balance what we are interested in is

the ending balance so when we give the

confirmation request we ask the customer

to confirm the balance meaning the

unpaid amount okay but if we are testing

for

transactions we will test the debits and

credits so imagine the t account for a

accounts receivable what would go into

the debit side of an accounts receivable

we will debit the accounts receivable

every time there is a credit sale right

we debit AR and then credit sales and we

will credit accounts receivable Whenever

there is a a collection we will debit

cash and credit accounts receivable so

in this case if you are testing the

transactions then you will be testing

credit sales and collections in relation

to accounts receivable of course so that

is the difference between test of

transaction and test of balances okay

now the other category of substantive

test is what we call substantive

analytical procedures or sap or in this

case analytical review procedures this

would involve a study and comparison of

relationships among accounting data and

related information we are working on

the context that uh there are

predictable relationships in the

accounts and that we we should be able

to identify unusual fluctuations and

when we identify these unusual

fluctuations that breach a certain

threshold then we would of course have

to investigate and focus on the rational

of these unusual relationships or

fluctuations we will discuss uh

substantive analytical procedures in a

bit more detail a few slides from now

okay but again the general categories

would be test of details and analytical

procedures we are also reminded that

between the two it would be test of

details that would be required to

performed as sub as substantive

analytical procedures are

optional okay now I know that you

already know the difference between test

of controls and substantive tests

whereby we say if the test of controls

would reveal that the internal controls

are reliable then we will perform less

substantive tests but what I would like

for you to reflect on right now is the

fact that test of controls only provide

evidence that a misstatement is likely

to occur

okay likely to occur meaning to say test

of controls show you the red flags test

of controls show you the likely okay

that there is a likely misstatement that

could occur it does not give you direct

evidence about the actual misstatement

and we know this to be true because uh

in our discussion on internal controls

we said not all deviations would result

to a misstatement remember our example

on how one of the control activities

would always be the wearing of an ID

when you enter a workplace or your

school the wearing of the ID would

ensure that only enrolled students get

to enter the campus but then we must

have reflected that well we have tried

at least once or you know entering the

campus without wearing an ID we are a

deviation because we did not wear the ID

but were we a misstatement the answer is

not necessarily we could have been

officially enrolled but we just left our

IDs at home therefore a control

deviation does not necessarily equate to

a misstatement okay it will be the

substantive tests that will provide the

existence or that will provide rather

evidence about the actual existence of

the misstatement this is the reason why

between the two substantive tests are

the required procedures and not test of

controls all right so I hope you were

able to reflect on that let's now look

at the different audit procedures

according to Nature

uh if we look at PSA 500 there are

actually seven listed audit procedures

according to nature but we're expanding

it a little bit here just to give more

context so we have of course what is

called inspection or examination of

documents this would include examining

records documents or even tangible

assets so in PSA 500 inspection refers

to both inspection of documents and

physical examination of assets of course

we know that there is a difference in

the way we perform these two in in a way

that if we talk about inspection what

you will be looking at are records or

documents and notice that the record or

the document by themselves do not have

any inherent value what do I mean by

this if you are holding a sales invoice

and the sales invoice has reflected

there that it was for a sale amounting

to 1 million the invoice itself the

paper the document is not worth 1

million right it's not worth 1 million

you cannot uh you cannot sell the

invoice for 1 million okay you cannot

bring it to the pawn shop and have it

pawn for a million the document itself

is paper and it does not H hold any

inherent value so when you're inspecting

something with no inherent value you're

inspecting a document you're inspecting

a record so we call that inspection

inspection of documents but when you

inspect a tangible asset say for for

example when you inspect a new school

bus the new school bus has value right

you can sell the new school bus you can

Pawn the new school bus so when you are

physically inspecting or physically

examining a tangible asset you are

inspecting something with inherent value

so again we can call it inspection of

documents physical examination of assets

but in PSA or Isa 500 they are both

referred to as inspection the other one

is observation and I'm sure you have

done observation so many times in your

life so observation would consist of

looking at a process or procedure being

performed by others observation is

widely used and it's very useful but it

also has its strengths and its

weaknesses just like any other audit

procedure but if we reflect one of the

strengths of observation is that you

could readily use this one when there is

an absence of an audit Trail when there

is no trail of documentation so

therefore you cannot inspect any

document then you can perform

observation however the weakness to

observation is that well we all know

that people tend to act differently if

they know they are being observed and

this is what we call the hawor effect so

we know also that our observation

whatever the results of our observation

will only be true for that specific

point in time we do not know if the

moment we have stopped our observation

or have left the place if people started

acting differently or in their more

natural state right so that is of course

a weakness of observation nonetheless

observation is still another procedure

that is widely used and then there is

what we call inquiry when we say inquiry

we simply seek information of

knowledgeable persons but if you want to

level up that inquiry into a more formal

uh structure than what you are actually

doing is a form of confirmation

confirmation consists of a response to

an inquiry to corroborate information

contained in the accounting records and

this response is in the form of a

written response so that's why it's

called confirmation so inquiry is when

we ask where confirm whereas

confirmation is when we request for a

written response okay to a particular

information that we wish to corroborate

so confirmation is a more formal

structure of inquiry and then we have

what is called computation or

reperformance when we say recomputation

sometimes we call this one recalculation

we check the mathematical accuracy of

the source document okay and accounting

records but when we talk about

reperformance reperformance is repeating

a client activity normally repeating a

client's internal control activity okay

so recomputation or recalculation will

be of course more in the figures so more

related to a substantive test but

reperformance would be to reperform a

control or rep performing a control

activity so this will be a test of

control and then we have also talked

about tracing and vouching but we will

review these Concepts again here so

tracing would involve establishing

completeness of the transactions by

following through from uh through the

accounting records so our direction of

the testing here is from documents to

records if you're still a little bit

confused about this just hang in there

we will uh we will resurrect our

discussion for tracing versus vouching

in the next slide okay and then of

course when we talk about vouching it's

the opposite tracing and vouching

actually Test opposite assertions right

vouching tests for existence it involves

following a transaction back to the

supporting documents or we sometimes

even call this one tracing back now

while we are familiar we Endeavor to be

familiar with the technical terms we

also need to recognize that in

literature and in the questions that are

asked in The Lure examinations it is

very possible for the examiner to use

tracing and vouching interchangeably so

please make sure to read through the

substance of the question and not simply

the use of the terminology okay we also

have what we call reconciliation and

this would of course involve agreeing

two sets of independently maintained but

related records perhaps in Intermediate

Accounting you are familiar with bank

reconciliation right so in audit we also

perform reconciliation of Records okay

and then analytical procedures which we

have mentioned a while back back okay

would of course consist of comparing

relationships between data to determine

reasonableness again working on the

assumption that we expect some degree of

predictability okay so again to

reinforce vouching versus tracing we

always say that in a perfect world

whatever is in the records would have

also appeared in the source documents

the records would represent the client

records and eventually this is what will

go into the trial balance and the

financial statements The Source

documents here would refer to the actual

existence or actual occurrence okay of a

balance or a transaction so in a perfect

world whatever is in the records would

have also been in the source documents

but like what we have pointed out the

world is not perfect and sometimes what

is in the records cannot be found in the

source document meaning to say the

client has recorded something that did

not actually exist or did not actually

happen can you imagine for example the

presence of ghost employees okay or

bloated purchases or sales that did not

actually happen so there they are

included in the records They are

reflected in the trial balance and

eventually in the fs but they did not

actually happen and they do not actually

exist so if you reflect on this one it

is found in the fs or in the records but

they are not there that means the status

of our records is that it is overstated

the records are overstated it reflects

something that does not actually

exist and in this case when the status

of the records is overstated we get to

ask the question where do you start do

you start from the records or do you

start from the documents and we get to

realize that hey we cannot start from

the documents why because there are no

documents in the first place right you

cannot start from the documents because

the documents are absent they are not

there because they did not actually

happen and so therefore in this case you

should start from the records and when

we start from the records to the

documents this is what we technically

call vouching and the assertion we are

testing here is existence now some of my

students use the pneumonic over to

recall this one o for overstatement V

for vouching E for existence and then R

to start from the records and then they

just take the opposite when it comes to

tracing okay so that might be something

useful for you to remember this as well

then monic over okay testing for over

statements means we have to vouch we are

testing for violations of existence and

we will start from the records over now

the reverse but also on the contrary

it's also possible that they do not

appear in the records but they actually

happen so this is the case of unrecorded

transactions unrecorded liabilities for

example so whenever we say unrecorded

that means the records are not complete

the records are are kolang no the

records are incomplete and if the

records are incomplete then the records

are

understated and as to the question of

where should we start from again we

reflect on the fact that well hey there

are no records I cannot start from the

records because there are no records so

we will start from the source documents

and this is what we technically call as

tracing and tracing will be a test for

completeness so here you will get to see

that existence and complete are actually

opposing no they they are opposite they

go in opposite directions whereas

existence would be concerned about

overstatements completeness would be

concerned about understatements whereas

existence would mean we will start from

the records completeness would say would

start from the source documents okay so

this is the difference between tracing

and vouching well I know for most of you

you already know this one so I hope you

didn't mind if we reviewed it again such

an important concept now here other

terms for audit procedures that you may

come across when you look at an audit

program or when you follow an audit

program you may see the term for example

agree so we normally say agree the

scheduled balances to the general ledger

this is of course in answer to our audit

objective of detail tie-in right we may

analyze account transactions compare

beginning balance with last year's

audited figures of course last year's

ending balance should be this year's

beginning balance right we count cash we

count inventory we examine documents we

foot totals right we read minutes of

director's meetings we reconcile cash

balance okay balance per book and

balance per bank for example we review

disclosures we review legal documents

and we scan for unusual items so these

are common terms that we use in

reference to audit procedures I'm pretty

sure you might be encountering more than

one of this when you leave later on work

in external audit and see an audit

program or maybe even make an audit

program okay so let's now give a summary

of the procedures classified as to type

and as to Nature now I always invoke The

Big Three The Big Three is IO inquire

inspect observe and I call them the big

three because they are present in all

three categories okay inquiry inspection

observation they can be performed as

part of risk assessment procedures they

can be performed as part of test of

controls and they can be formed as part

of substantive tests whether rap or fap

you may perform the big three

reperformance is rep performing a

control activity so therefore that is

called test of controls okay when you

are

recalculating you are rep performing the

calculation you are

recalculating then that's a different

story and that should be substantive

test confirmation is a substantive test

again we'll talk a bit more about this

in a few recalculation as what we have

have mentioned is also a substantive

test analytical procedures may be a risk

assessment procedure if performed in the

planning phase and if performed in the

testing phase then they are also

substantive tests so you would notice of

all of the procedures only the big three

has has checked all three categories

right so that's why I call them the big

three now let's talk about external

confirmations external confirmations of

course incompass the process of

obtaining an evalu waiting audit

evidence through a representation or

information of an existing condition

okay directly from a third party in

response to a request for information

about a particular item affecting

assertions in the fs or related

disclosures as what we have mentioned

this is a more formal level of inquiry

where we request no for a written

response these are situations whereby

external confirmation is ordinarily used

uh like for example example confirmation

with bank balances and other information

we normally confirm as well accounts

receivable okay then stocks held by

Third parties property title Deeds we

can also confirm Investments that are

still in the hands of the stock Brokers

we can also compare liabilities like

loans payable and accounts payable so

these are just some of the situations

where confirmations may come in handy

there are two um General categories of

the form of confirmation there is what

we call positive confirmation and under

positive confirmation we ask the

respondent to reply in all cases whether

the respondent agrees with the

information or disagrees with the

information in all cases we ask the

respondents to reply whereas if we talk

about negative confirmation we only ask

the respondent to reply if and only if

the respondent disagrees with the

information therefore under negative

confirmation if we do not not receive

any response then we would assume that

the the information is correct right

with this you will get to to notice that

there is a higher risk associated with

using negative confirmation because we

cannot just readily assume that a

non-response means everything is okay

right what if the respondent did not

receive the confirmation letter what if

the respondent received it but did not

read it right what if the respondent

does not exist at all that's why the

respondent didn't reply so there are

certain conditions where negative

confirmation may be used okay like for

example when the assess risk of material

misstatement is low or when there are a

large number of small balances you have

accounts receivable for example totaling

1 million but there are also 1 million

customers in that accounts receivable so

on the average a peso per customer so a

large number of small balances or a

substantial number of Errors is not

expected or when you have no reason to

believe that the respondents will

disregard the request so when these

conditions are met if one or more of

these conditions are met then normally

the auditor will go for negative

confirmation the usual format though or

form though is a positive confirmation

there is also what we call a blank

confirmation blank okay meaning to say

we do not uh provide the information

okay we do not populate the letter with

or the information request with the

information that we have at hand we

leave it blank and we ask the respondent

to list down okay for example we

normally use this one for banks we ask

the banks for example to list down all

accounts that our client has with that

bank and any relevant other information

such as if there are any leans or

pledges and stuff like that so that is

what we what is called a blank

confirmation positive and negative

confirmation is generally used to test

for the assertion of EX existence okay

that's really the the usual assertion

tested by confirmation existence but

notice if you use blank confirmation a

blank confirmation can even test for

completeness but as I've mentioned we

normally use this one with banks we

don't normally use blank confirmation

with customers because I think you can

imagine how you would feel if you are a

customer and you receive a blank

confirmation it would just increase you

know instances of not non response okay

but it's there blank confirmation is a

type of confirmation let's reflect on

some general points to remember when it

comes to confirmation such as for

example have you ever wondered who

stationary or letterhead we will use

when we write the confirmation request

and who signs the confirmation request

right so here are some general points to

remember confirmation letter should be

printed on the client's letter head or

the client's faximile or email and

signed by the client officer not the

auditor okay remember that in the case

of AR the customers of the client are

not doing business with you they are not

doing business with the auditor for all

intents and purposes they do not know

the auditor and so therefore it should

be the client who will write the letter

to them use the client stationary use

the client's fact simul or email and

then let the client sign it the auditor

should be very careful that the

recipient's address is reliable and not

subject to alteration by the client in

such a way as to misdirect the

confirmation okay such as instances for

example of failure of delivery mainly

because the addresses have been altered

so we should be cautious about that one

the request should seek information that

the recipient can supply so do not make

it too overwhelming for the recipient

okay ask for information that they can

supply for example the amount of a

balance or the amount specified in

invoices or notes the confirmation

should be directly controlled by the

audit firm meaning to say while the

client signs the letter the audit firm

supervises the mailing of the said

confirmation request they should not be

given to the client Personnel for

mailing because in that case there's

always the risk that they may not

actually mail those confirmation

requests to customers which they know

will have disputed accounts or which

they know do not actually exist

right so the auditor should control The

Mailing and the responses should be

returned directly to the audit firm not

to the client okay so these are some

general points to remember for

confirmation request now very quickly

let's look at analytical review

procedures as well so particularly

analytics performed in the testing phase

so here are some factors to consider for

example is it suitable to use

substantive analytical procedures given

the assertions for example if you want

wanted to test for the assertion of

Rights and obligations I hardly think

substantive analytics would be a good

fit right so determine the suitability

of using the substantive analytics

second consider the reliability of the

data and we have talked you know in

detail about the hierarchy of evidence

reliability right so we consider the

reliability of the data whether they are

internal internally generated or

externally sourced okay and then from

which the expectation of recorded

amounts or ratios are developed later on

we get to see that when we perform

substantive analytics we develop an

expectation so we determine or we

consider the reliability of the data

that becomes the source of this

expectation and of course the subsequent

testing then we consider whether the

expectation is sufficiently precise to

identify a material misstatement at the

desired level of assurance take note

it's an expectation so it could never be

accurate that's why we're saying just

sufficiently precise to give us that

desired level of assurance okay and then

of course the amount of any difference

of recorded amounts from expected values

that is acceptable in other words we

determine the threshold okay

so because later on whatever would

breach the threshold is what we will

investigate so when more persuasive

audit evidence is desired from

substantive analytics more predictable

relationships are necessary to develop

this expectation let's look at some you

know general rules of sum when we talk

about predictability of relationships

for example relationships in stable

environments are definitely usually more

definitely usually are usually more

predictable than relationships in a

dynamic or unstable environment so if

you talk for example about an economy

that is in turmoil right so information

or relationships may appear to be less

predictable in those cases so

relationships in stable environment

usually more predictable also

relationships involving income statement

accounts tend to be more predictable

than balance sheet accounts why if you

can imagine the heading of an income

statement it says XYZ company income

statement for the year ended meaning to

say whatever happens or whatever is

reflected in the income statement is

only for a certain period only from the

start of the year to the end of the year

it will be quite easy for you to predict

what happened within a year right as

compared to a balance sheet notice the

header of the balance sheet XYZ company

statement of financial position for we

don't you don't say for the year ended

you say as of December 3120 whatever so

if you can imagine as of December 31

2024 for example that means from the

time of the Inception of the company

until 2024 imagine if the company was

you know if the company was organized or

was given birth to as late as not as

late as early as 1960 so that means from

1960 to

2024 that's quite a long period of time

and that's quite a lot of happenings in

in Filipino we say in our slang we say a

lot of gups from 1960 to 2024 right a

lot of things must have happened within

that period of time so because of that

income statement account accounts which

only cover one period is more

predictable than balance sheet accounts

which would be as of no a specific point

in time so there and then of course

relationships involving transactions

subject to management discretion may be

less predictable such as for example

estimates okay so these are some of our

general rules with regards

predictability let's now look at the

elements or steps when we use

substantive analytical procedures we

start by developing an expectation of

the recorded amount and then we

determine the amount of variation

between the expectation and our

threshold if the difference is material

we make inquiries of management so

investigation of variations that cannot

that cannot be accepted without

explanation if we cannot get the

explanation or the evidence is not

adequate then consider conducting other

audit procedures however let me point

out to you that when we use analytics a

substantive test okay like what we have

said we develop expectations about the

fs We compare the fs with the

expectations developed is a significant

is the differ significant no if not we

accept the account as reasonable meaning

to say not all differences will be

investigated that's why it's important

for us to develop the threshold okay so

if the difference breaches the threshold

then we conduct further investigation

okay allow me to backtrack a bit also by

saying that before before we develop any

expectation or compare the fs etc etc as

per usual we of course have to first

understand okay we first have to

understand how management came up with

the estimate how management uh came up

for example no with um these particular

information in the fs that's a given

right and then we understand the

industry we understand the environment

we understand the entity okay those

levels of understanding that gtky will

lead us to our expectations all right so

there that will be using analytics here

are some of the ratios commonly used now

this is I know a Management Services

topic but let's just very quickly run

through some of the ratios and what

could be its audit significance for

example one of your favorite ratios of

all time current ratio okay the audit

significance of the current ratio is

that if you have ever noticed a

significant increase in the current

ratio compared to last year here it may

indicate a completeness problem okay may

it may indicate however it may also be

influenced by changes in asset accounts

so therefore while we are aware of the

possibility that the completeness

assertion may have been violated that is

why there's a significant increase or

movement in the current ratio we also

acknowledge that there may be valid

reasons that's why we have to

investigate another favorite ratio used

in substantive analytics is the accounts

payable ter

uh days okay so prior experience in

account payable turn days or the turn uh

uh turn days no for accounts payable

combined with the knowledge of current

purchases can be used in estimating

current payables a shortening of this

period May indicate completeness

problems for the audit side as well okay

but again there may be valid reasons why

the ratios are changing another is

inventory growth to cost of sales growth

so if we have found ratios larger than

one it may indicate that inventories are

growing faster than sales the business

is amassing more inventories than they

can sell right large ratios may also

indicate possible inventory of solence

problems because it would seem like the

company is not able to sell okay their

inventories as quickly as we would have

expected them in case of fixed asset

turnover an unexpected increase in fixed

asset turnover May indicate the failure

to record or capitalize the aable assets

okay for in the case of free cash flow

negative free cash flows indicate the

need for expected financing it might

mean that the company might look into

debt financing okay in the future

drawing down on cash Investments so

there are uh implications to the ratios

that we have seen so in the case of

audit we are not super concerned with

the formula of course we need the

formula to come up with the correct

ratio but we are giving more emphasis on

its audit significance okay and then

lastly let's very quickly talk about

accounting audit estim auditing rather

accounting estimates we know that

estimates carry with them a certain

level of inherent risk so it's an

approximation of an amount or item in

the absence of a precise means of

measurement and it is this approximation

that makes it

vulnerable to risks here are some

examples of estimates I'm sure you have

met them at one point in time allowance

for doubtful accounts allowance for

inventory obsolesence your favorite

depreciation acels okay uh in the case

of deferred taxes Provisions for losses

and losses and Contra construction

contracts and even Provisions to meet

warranty claims so these are just some

of the many estimates that we will en

encounter in an audit of financial

statements so what are the procedures to

test accounting estimates similar to

everything else we of course always

start by an understanding of how

managements management comes up with

these estimates and then we test the

process used by management to develop

the estimate we develop our independent

expectation and then we review

subsequent events or transactions so

notice that just like analytical

procedures we also develop an

expectation for the estimates right so

in this case however we start by testing

managements process then developing our

independent expectation we could also

review subsequent events or transactions

such as for

example if you can reflect on scrap

value or salvage value being the

estimated uh value of the asset at the

end of its useful life right meaning to

say if you're going to take that

imagination a bit further if that's the

estimated value of the asset at the end

of its useful life then if you're able

to sell the asset at the end of its

useful life the proceeds should be the

same as a salvage value right in a

perfect world and so therefore one way

of testing the estimates is to look at

the subsequent event you look at an

actual sale of an asset that has reached

the end of its useful life and then

compare the proceeds with the salvage

value or if you talk about acral for

example acur expenses like acred

utilities okay in order to test that you

could always look at the subsequent

actual payment of the utilities that

were acur okay so that is what we mean

by review Subs quent events or

transactions all right so that's it for

audit procedures when we come back it

will be all about audit evidence and

documentation which will neatly you know

seal off this installment Series so I

mean this this lecture series on audit

objectives procedures evidence and

documentation so I hope to see you in

the next video to talk about audit

evidence and documentation